Case 1:05-cv-00503-TCW
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Defendant's Exhibit # 17
B-152
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Document 30-5
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Page 2 of 54
OMS No Lt4Z3
Fø 1120 ii1__s. _ 01_ T~
Fa i-~ 1~i7 or"'", DInnln . ,1- . en
1111
U.S. Corporation Income Tax Return
,"-
.1997
. E.1c....tin__
C D__,po_
t.
A Chec ifi:
1 eo-ii_ _ rv I_FonI51) Z __ ho- DlA i- .. PH
IRS
24-0615177
3 ii .-A-i p 1111. 1M d'" In T... D prlll l- .. 1.41""
1
WI.,
Otir-
Iabil.
09/07/1938
D i_ -l-pelol
r i.
In~
z
s
.
6
j
&
7
.
II
10
11
12
1S
14
111
11 17
1.
l'
·l
20
21
a
22 23 24
2i
28 27
28 i-i _ be.. ~ i- eM ii -i iM -- ii 27 "" Ii 11
29 La:. Nel operating 10$ deductn ......................................................... 29.
h 2911 70 3.
gains (at Form 2439) ................. 32
so TUllllilnaml. SublfIlne 29 frm In 28 ......................................................................................... 31 Tø1ltli (Scedule J, lin 10) ..... ........ .....................................
16,106,800.
2 370 632. 5 505 594.
j 1
.
~
Ie
32 ~:~ ,~.~....... 32 II 1997estimitødta~nt ...... 500,000c ~:~nd~~.................... 32 dBaI ~ 12.
, Crellforta paid on undistributd capitl II Cllllfor
i Taxdeposltid wI Form 7004 ................................................................... 321
la on fuils (atlch Form 4136) ........................................... 32 Fedral
5,750,000.
as Estimate ta penaly. Chec if Form 2220 Is atched ........................................................................... ~ S4 Tii dui. If Ine 321 is smller than the toll oflis 31 and 33. ener amount ow ................................................
35 oyrplymint.1f 1i32h Is Iargirth thlotal of lin 31 and 33, inter amount ovrpid .......................................
.
Sign oo _ co' ~ · ii on". inbm of . l- -l ki- . Here
Piid
Pre-
38 Enter amount olBne 35 u : redlle I 199 I ~ 244 406. Refunded ~ sa Und..po o'~.1 d_ _1__~i. Nlm, -i11' ecmp11' açlli- _.- on "'.. - oflT ~_IMi. ~. IN
pll8r'
II.
Only
~-i ,. IN I't~..( ti;ll,M
Rm'. ..
i.
en ..
Ii ~ooiM~I'l1"'; 56.. '100(;
E li/1sta 1Lc.",9 ¿.¿ ,/J
r~~::07 JWA
10200804 758075 394C68829CC
050 HOSPI~5~ERVICE ASSOCIATION 0 394C68S1
NEPAOO1166
i
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24-0615177
HOSPITAL SERVICE ASSOCIATION OF NORTHEA
FORM 1120
COMBINED OTHER DEDUCTIONS
COMBINED AMOUN:iS
STATEMENT 11
t
HOSPITAL SERVICE ASSOCIATION
HMO OF EASTERN
NORTHEASTERN PHYSICIANS PENSYLVANIA, GROUP, PC
ADMINISTRATIVE AND PROCESSING COSTS AUDIT, CONSULTING
'26,944,119.
696,500. 351,285. 553,199,737. 1,091,277. 608,262. 810,433. 396,235. 40,572.
3,412,700.
20,922,809.
617,421.
180,687. 13,177.
AN EXTERNAL
SERVICES
AMORTIZATION
7,750,596.
BOAR EXPENSE
CLAIMS EXPENSE
COMMISSIONS
DUES AND SUBSCRIPTIONS
EMPLOYEE RECRUITMENT ,
409,000. 6,812,805. 387,690. 295,633. 101,242. 250,043. 316,268,979. 236,930,758. 482,713. 608,564. 199,552. 395,563.
10,444.
RELOCATION AND
LICENSES
INSURCE
MISCELLAOUS
MEALS AND ENTERTAINMNT
POSTAGE
PRINTING
HAD SERVICES IECURITY
SUPPLIES
TRAVEL
CENTER COSTS SOFTWAR EXPENSE
UTILITIES AN
TELEPHONE
TOTAL OTHER DEDUCT.
1,416,818. 77,369. 3,720,834. 929,054. 152,519. -550,733. 1,405,632. 2,266,587. 992,228. 2,282,844. 604,642,168.
811,306. 336,316. 40,572. 1,005,150. 39,898. 2,542,975. 451,809. 151,606.
59,127. 12,574.
395,950.
37,024. 1,171,183. 477,168.
42,625. 3,516.
1,300.
253.
i
-550,133. 1,405,632. 1,612,106. 729,447. 1,824,439.
338,444,810.
451,684. 223,965. 407,507.
144,181. 35,156.
183.
262,669,946.
1,048,943.
.
36 STATEMEN(S) 11
10200804 758015 394C68829CC
050 HOSP~~4SERVICE ASSOCIATION 0 394C6851
NEPAOO1204
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Document 30-5
NORTHEA
Filed 02/28/2007
Page 4 of 54
HOSPITAL SERVICE ASSOCIATION OF
FORM
24-0615177
STATEMT 11
MAAGED CAR, MAAGED CAR
INC.
HOLDING
UNIVERSAL
I
1120
COMBINED OTHER DEDUCTIONS
UNIVERSAL
MAAGED CAR
REAL ESTATE
AXiS SERVICES,
UNIVERSAL
INC.
ADMINISTRTIVE AND
PROCESSING COSTS AUDIT, CONSULTING AND EXTERAL SERVICES
AMORTIZATION
1,646,611.
66,064.
2,800.
BOAR EXPENSE
CLAIMS EXPENSE COMMISSIONS . DUES AND SUBSCRIPTIONS
EMPLOYEE RECRUITMENT ,
RELOCATION AN
LICENSES
INSURCE
MISCELLAOUS
MEALS AND ENTERTAINMNT
POSTAGE
265.
3,986.
70.
PRINTING ~ITY
D SERVICES CENTER COSTS SOFTWARE EXPENSE
SUPPLIES
TRAVEL
UTILITIES AND
TELEPHONE
TOTAL OTHER DEDUCT.
3,065.
L
1,650,597.
66,134.
.
37 STATEMENT(S) 11
10200804 758075 394C68829CC 050 BOSPI~~ERVICE ASSOCIATION 0 394C6851 NEPAO1205
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24-0615177
HOSPITAL SERVICE ASSOCIATION OF NORTHEA
FORM
t
1120
COMBINED OTHER DEDUCTIONS
EASTERN
STATEMENT 11
PHYSICIANS
FIRST PRIORITY LIFE
MAAGEMT
INSURCE
ADMINISTRATIVE AND PROCESSING COSTS AUDIT, CONSULTING AND EXTERNAL SERVICES I ZATION AMORT
278,514.
345,304.
BOAR EXPENSE
CLAIMS EXPENSE COMMISSIONS
DUES AN
SUBSCRIPTIONS
EMPLOYEE
2,703. 4,720.
RECRUITM ,
RELOCATION AND
INSURCE
LICENSES MISCELANEOUS
7,88l.
5,376.
194.
MEALS AN
POSTAGE
ENTERTAINMET
~ITY D SERVICES
PRINTING
CENTER COSTS SOFTWARE EXPENSE
77.
9 13.
TRVE
SUPPLIES
58,616. 3,660.
50,715 .
UTILITIES AND
TELEPHONE
TOTAL OTHER DEDUCT.
758,673.
.
38 STATEMENT(S) 11
10200804 758075 394C68829CC
050 HOSPI~tfERVICE ASSOCIATION 0 394C6851
NEPAO1206
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Defendant's Exhibit # 18
B-1'57
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Valuation of the Employer Group Contracts Subscriber Base and the Assembled Work Force of
BlueCross of
Northeastern Pennsylvania
as of January 1, 1987
il ERNST & YOUNG LLP
~i'~ltl~%~t~~Æ!!~
B-158
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J
E! ERNST & YOUNG LLP
. Two Commere Squae
Suite 40
2001 Market Stree
. Phone: 2154485000 Fax: 215 448 4069
J
J
'J
Philadelphia Pennsylvania 19103-7096
April i 0, i 997
Mr. Michal P. Galagher
1
BlueCross of
Senior Vice President, Finance and Corporate Treasur Norteas em PeMsylvania 70 Nort Mai Strt
Wilkes-Bar, Pennylvana 18711
J
-1
Valuation of
Certain Intangible Assets as of January i, 1987
Dear Mr. Gallagher:
-J
At your request, we have performed a valuation stuy to provide our reommendation of the
fair market value of cert intagible assets of BlueCross of Norteaer Pennsylvania
J J J
J
ì
I
("BCNEPA") as of Janua I, 1987 (the "valuation date"). The intagible assets appraised
include the employer grup contrts subscriber bae and the assembled work force. The
stdy wa conducted solely for feder income ta puroses relatig to the frsh sta
prvision of
the Tax Reform Act of 1986, and is expressly subject to the athed Statement
of Gener Assumptions and Limitig Condtions.
Our stdy was peormed in accordance with the Uniform Standards of Professional
Appraisal Practice as promulgated b~y Apprasa Foundation. For the purses of this
stdy, the ten fair market value is d ed as the price at which propert would change
hans between a willin buyer and a '11ng seller, neither being under any compulsion to buy or sell and both havig reonable owledge of the relevant facts.
~
The accompanying report describes the valuation methodologies followed and procedurs
L i ,.
applied in peormg ths valuation stdy. The working paps tht support our valuaon
will be retaed in our files and ar available for your refernce. Bas on th valuation
principles, procedures, assumptions, and limiting conditions described with the
accompanying reort, we recommend an aggrgate fai market value for the employer group
ì
.
,
contrts subscriber base of THRTY-TWO MILION FOUR HURED EIGII-FIVE
THOUSAN DOLLAR ($32,485,000), as of Janua 1, 1987. Ths aggate value ha
been calculated on a per employer grup contrct basis, as desribed in detl in our rert
1
J
ì
Furermore, we reommend an aggrgate fa maret value for the assembled work forc of
SIX HURED FIFTY-NI THOUSAN DOLLAR ($659,000), as of Janua i, 1987.
J
1
Th aggrgate value ha also bee calculated on a per employee bais, as described in detal in our report.
J
1
~
Ernst & Young LlP is a member of Ems! & Young InternationaL. ltd.
B-159
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J
g ERNST & YOUNG LLP Mr. Michael P. Gallagher
J
BlueCross of
April 10, 1997
Page 2
Northeasern Peiulvana
J
If you have any questions concerng our recommendations or this report, pleas call either
Lee C. Russell at 215/448-5099 or Cliford R. Jones at 214/448-5016.
j
)
J
L
Very trly yours,
~THLP
J
1
L
Copy to: David Bobonski, BlueCross of
Norteastern Pennylvania
J
Clifford R. Jones, Er & Youn LLP Lee C. Russell, Ert & Youn LLP
J J J
J
J
J
J
J
B-160
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.
Statement 01 General Assumptions and Limiting Conditions
Our anysis aÎd recommendations ar contingent on the following general assumptions and
limiting conditions:
All facts set fort in this report ar materly tne and correct to the best of the consultats' knowledge and belief.
We have relied on information provided by the management of
BCNEPA and
tre and
other thrd paries (including public sources and sumies thereof) without
independent verification, Whle we believe these sources to be
accurte, we make no waranty thereof.
We have no financial interest in the propert anlyzed and the fee for this
engagement is not contingent on the fidings reprtd herein.
Ths report is intended for us only by the par to whom it is addrsed and
only for the purose described. Mere possession of this report does not
convey a right of reliance, nor may any reliance be plac on it by any par for any puiose other th tht for which it was prepaed.
Ths report may not be distbuted either in whole or in par to any third pa.
other th the Internal Revenue Serice or your auditors, without the prior
wrtten consent and approval ofEmst & Young LLP.
We have not, as par of
this valuation anysis, audited reviewed, or compiled
either the hisorical or prospctive fiancial results in accordance with
generly accepted auditing stadads, and so express no opinion thereon in
ths vauation report,
Transaction prices reflect specific circumstaces and considerations other than fair market value. Such factors include but ar not limited to: (I) the number of potential buyers; (2) potential synergism and sttegic opportties arsing urgency atthed to the from business or asset combinations; (3) the degre of
sale or acquisition of the assets anyzd; (4) persna (as opposed to
ecnomic) goas of the paes; and (5) significat ta benefits unque to the specific transactions. We do not wat tht a buyer for the apprased assets
would be found at the fair market values rerted herein.
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Estmates of events following the valuation date used in our anlyses represent mangement's genera expectacy concernng such events as of the valuation date. These events may not occu as anticipated, and actul operating results
may var materially from those described.
Ernst & Young LLP is not obligated to update ths report for events
subsequent to the valuation date, AU services subsequent to delivery of the report, mcluding meetings, tesmony or deposition in cour or before any governental agency, will be provided at our standard biling rates plus
expenses.
Except as specifically stated to the contra. ths analysis has given no
consideration to: (l) matters of legal natu, including issues of legal title and
compliance with federal, stte, and local laws and ordinces (including laws, regulations and ordinaces); (2) environmenta and engineenng medical
isses, and the costs associated with their correction; (3) issues concerning the
adequacy of fuding for pension and/or health
care liabilties; and (4)
litigation and other contingent liabilties that ar not reorded on the balance
sheet. The user of our findings is responsible for makng his/her own detenation about the impact of these mattrs on the findings reponed
herein.
The recommendations reprted herin represent the considered judgment of Ernt & Young L1.P and the identified valuation consultats based on the facts, analyses, and methodologies described in the report or in our working
papers, but should be considered as advisory in natu. It is importt to note
that the Internal Revenue Service may challenge deductions claimed for abandonment losses relating to intangible assets. While we have applied
generally accepted valuation procedures and methodologies in the valuation of
the employer group contrcts subscriber base and the assembled work force,
we canot promise or guarantee success that the methodology we have
employed will rest in a susnable deduction for BCNEP A, either
admisttively or judcially if challenged by the Inte Revenue Service.
BCNEP A management was provided a copy of ths report prior to final
issce to ensur the accurcy of the facts and opinions attbuted to them.
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CERTIFICATE OF APPRAISER
I certfy tht, to the best of my knowledge and belief:
The statements of fact contaned in ths report ar tre and corrct.
The reported analyses, opinions, and conclusions ar limited only by the reported
assumptions and limiting conditions, and represent the unbiased professiona
anyses, opinions, and conclusions ofEmt & Young LLP.
Ernst & Young LLP has no present or prospective interest in the propert that is the
subject of this report and has no personal interes or bias with respect to the paries involved.
Compensation for Ernt & Young LLP is not contingent on an action or event
resulting from the anyses, opinions, or conclusions in, or the use of, this report.
The analyses, opinions, and conclusions were developed, and ths report ba been
prepared, in conformity with the reuiments of the American Society of
Apprsers and the Uniform Standards a/Professional Appraisal Practice.
Individuas who provided significant professiona assistace in the completion of
ths engagement include Fraces W. Ferguson, Roderick A. Mundy, John
O'Connor, and Keith D. Studnck. Jil L. Voigt sered as review appraiser.
The Amercan Society of Apprasers has a mandatory recerfication progr for all
ofits Senior member. I am in compliance with the requirments of
that progr.
April 10, 1997
-dL~~~
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TABLE OF CONTETS
i. INTRODUCTION.. .... ............ .......... ......... ............. .............. ............ ..........., ......1 the Valuation and Assets Apprsed ......................................1 A. Purose of
B. Definition of
Fai Market Value ..............................................................2
II. BACKGROUN INORMTION ........ ........... ................... ................ ........,.....3
A. Description of the Business ..................., ....... ............ ............, ...........,.....3
B. Descrption of
the Employer Group Contrcts Subscriber Base..............5
C. Descnption of
the Assembled Work Forc.............................................1
III. VAL UA nON, . ...,.....................................,.................. ,.......,............ ........ .........8
A. Intruction.......... ......................... .......................,................... .............8 i. Cost Approach ................... ................................ ........ ..............8
2. Market Approach,... ................. ....... ...........................................,.9 3. Income Approach.... ......... .................................. ........... .... ..........10
B. Information Resources .... .................... ........ ............ ........ .......... ..... ........" i 1 Bas ................13 the Employer Grup Contrcts Subscriber C. Valuation of
1. Introduction......... ....... ..... ........ ........................... ........... ............. i 3
2. Premum Revenues ...... .............................................. ............ .....15 3, Life Study Analysis..... ............. ................................... ........ ......... i 5
4. Clais Expns, Gans from Undertig and Oprating Expenses................................................... ...... 18
5, Unadjusd Net Cash Flow Attbutable to Contrts................. i 9. 6. Estimated Ret Required on Other Asts Employed ............20 the Adjusd Net Cash Flows 1. Discounting of
Attbutable to the Contracts .......... ................... ..... ................ .22
8. Benefit of 9, Recommendation or
Tax Savings from Amorttion ................................27
Value ................. ........... ............ ..... ........... .27
i O. Measurment of Abandonment Losses ....................................28
D. Valuation of
the Assembled Work Force......................................................29
i . Intruction.......................,............... ......... ............................... .29 . 2. Hing Costs ......................... ......................., ............ ......... .......... .29 3. Training Cost .................. .......................... ............... ........ .........3 i Value .........................................................3 i 4. Recommendation of
S. Measurment of Abandonment Losses........................................32
E. Sumar and Conclusion ...... ....... ........ .............., ............ .......,... .............34
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TABLE OF CONTENTS (Contiued)
LIST OF EXHIBITS
A - Historical Compartive Balance Sheets B - Historical Compartive Income Statements
C - Anlysis of Claims Expenses, Underwtig Gai, and Operatig Expenses
D . Surval Probabilty Functions
E - Sample Valuation of
Selected Employer Group Contrcts
the Assembled Work Force
F. Valuation of
APPENIX (under separate cover)
Values ~igned to Employer Grup Contrts and Individua Employees
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I. INTRODUCTION
A. Purpose of the Valuation and Assets Appraised
The purose of mis valuaion is to provide our recommendation of the fair maret value of em Pennsylvania (herinafer referred to as Norteast certn intagible assets of BlueCross of
"BCNEPA" or ''te Company'') as of Janua 1, 1987 (the "valuation date"). The intangible assets appraised include the employer grup contrts subscnber base and the assembled
work force. It is our undersding tht our recommendaons are to be used solely by
BCNEP A magement in evaluating a ta strtegy to claim a ta deduction in each year
subsequent to Janua 1, 1987, baed on actu abandonment/turover of
the employer group
contracts and the BCNEP A employees.
BCNEP A requires valuation assistace as it considers the practicaity and advisability of tax the Tax Reform Act of 1986 ("TRA 1 986"), strategies related to the "frsh st" provision of
As stated in Section 833 ofTR 1986, Blue Cross and Blue Shield organzations became
taxable entities, effective with their first taxable yea begining after Decembe 31, 1986, and
to be taable in the same maner as stock proper and casuaty inurce companes. The
"frsh st" proviion, as descnbed in Section 833, prvides for the Blue Cross and Blue
Shield organzations to be given a frsh star with respect to changes in accounting methods
resulting frm the change from tax-exempt to taable sttus.
The Committee Report on Public Law 99-5 i 4 (the "Committee Reports") fuer explained
me effect of the frsh sta provision on Blue Cross and Blue Shield organiztions by stating
tht for puroses of detennining gain or loss, the adjusted basis of any asset held on the first day of the fist taxable yea afer December 31, 1986 shal be treatd as being equa to its fair market value as of tht day. Thus, for the formerly ta-exempt Blue Cross and Blue Shield
organzations utlizing a calenda period of accounting and whose firs taxable year
commenced Janua I, 1987, the basis of each asset of such organtion is equa to its fair
market value on Janua 1, 1987. The Commtte Reprt fuer stted tht the basis
adjustment was being provided beause the conferes believe tht such formerly ta-exempt
organizations should not be taxed on uneaize appreciation or depreciation that accrued
durng the period the organton was not generaly subject to income taation.
1.
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B. Definition afFair Market Value
For the purose of this analysis, the term/air market value is defined as the price at which
prperty would change hands between a willng buyer and a willng seller, neither be.ing
wider any compulsion to buy or sell and both having renable knowledge of the relevant
fact.
2.
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II. BACKGROUND INFORMTION
A. Description of the Business
BCNEPA was founded in 1937 as Hospital Service Association of Northeastern
Pennsylvana. The Company is a PennsylvaIa nonprofit Hospital Plan Corpration and independent licensee of the Blue Cross and Blue Shield Association, operating in thirteen
counties in norteasrn and nortcentr Pennsylvania.
In 1986, though its traitiona products, the Company provided healthcare coverage for both
high and low risk individuas, includig subscribers in its private progras and Medicar
beneficiares. BCNEP A provided trditiona indemnity heath inurce tht included basic,
major medical, and comprehensive major medica coverage. In addition to its traditional
indemnty business, BCNEP A offered a prescnption drug plan and parcipated in
governent progras. While the Company first began to offer a manged ca product
during 1986 and 1987, durng the late 1980s there was very little penetrtion of maaged car
in the Pennylvana maret area in which BCNEP A operated,
According to information contaed in BCNEPA's 1986 Annual Report and other internal finacial report, the Company sered over 654,000 subscribers (i.e., insur individuas) in
1986, representing approximately two-thds of the population base in its market area. There
we~ approximately 359,000 cusomer acounts near the valuation date, representing local
and ar businesss and individua policies. Near the valuation date, the Company's provider
network consisted of approxiately 30 contrcts with acute car hospitals in its market area.
Tota revenues for 1986 were $244.9 millon, comprised of $69.6 milion from nationa
groups, $123.8 millon frm local groups, and $51.5 milion from non-groups (i.e.,
individuas). The Company had a cost effcient system that allowed it to ran as one of the
nation's bes Blue Crss plan in contrlling o~rating expenses and admiistrative costs.
Claims incurd durng 1985 were $240.2 milion and, afer the inclusion of investment and
other income and the deduction of operatig and admstrative expenss, net income w.as
$3.2 milion. Claims incured durg 1986 wer $237,2 millon and, afer the inclusion of
investment and other income and the deduction of operating and administtive expenses, net
income was $18.5 milion. The Company held assets ofsin.1 millon and $194.0 millon at
3.
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December 31, 1985 and 1986, restively, with a sulus resere of$7S.1 milion and $93.6
milion. Additional financial informtion, in the form of hiorical consolidated balance
sheets and statements of
income for 1982 though 1986, are presented in Exhibits A and B.
As of the valuation date, BCNEPA's subsidiares included HMO of Norteastern
Pemiylvania, Inc. ("HMO"), a wholly owned subsidiar, and Universal Managed Car, Inc.
("UMC"), a 70 percent owned company. HMO is a health matenace organzation, and in 1986 wa in a development stge and did not ear any revenues from its activities. UMC
developed and provided consultative cost contanment services for insurers, businesses and
industr, In addition, the Compay was a 50 percent joint ventu paricipant in the Shared Services Center and owned 50 percent of the outstaing common stock of Northeast
Pennsylvania HMO Management, Inc.
4.
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B. Description of the Employer Group Contracts Subscriber Base
Premiums eared from insurce coverage contrcts represent substtially all of the
Company's revenues. Insurce c~verage contrcts include coverage for hospital and/or
other medical servces in the followig genera categories: basic, drg, and major medicaL.
Contrcts ar entered into with local ara businesses, national accounts (in which the
Company may sere as the "contrl plan" or as a "paricipant"), individuals, and though
pacipation iIi Federal Employee Progr plan. As previously mentioned, there were
approximately 359,000 contrcts existng near the valuaton date, covering over 654,000
subscribers (i.e" ins individuals). Accordingly, the subscriber base that ex.isted as of
Janua 1, 1987, was of considerable value to the Company.
The segment of BCNEP A' s subscrber base that was considered to account for the greatest
proportion of value was the employer group contrcts. Employer groups accounted for
almost 80 percent of total anual subscrption income; as previously mentioned, in 1986
subscription income frm employer grups (including nationa groups and local groups)
totaled approximately $193.4 millon, out of a tota of$244.9 millon in subscrption income. Contrcts with individuas have not been valued beuse of their relatively low profitabilty
and their association with the Blue Cross and Blue Shield broader mission of providing
insurce to poor and high risk subscribers.
The employer groups consist of ara and loca businesses, unons, associations, and health
and welfare fuds. At Janua I, 1987, there were 8,865 active employer group contrcts.
Groups are primarly ara and local; however, BCNEPA had several hundred major national
accounts for which it served as the "contrl" agent. Local groups raged in size from small
businesses with severa employees to large organtions such as Wilkes Bare General
Hospital and Scranton School Distrct. National grups included compaJes such as General Dynamics and Proctor & Gamble.
Coverage ratings for the employer groups include both "communty" rated groups, which
allow for small (less th 100 individua subscribers per employer group) groups to pool their
risks and receive coverge at the same rate, and "experence" rated groups, which allow large
(over 100 individua subscrbers per employer group) grups, with risk spread over a larger
population, to receive more favorable coverage ratings.
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As of
the valuation date, BCNEPA had significant market share but wa beginning to feel the
effects of a more competitive marketplace. The Company was beginng to face competition
from other insurance and alternative delivery companes (e.g., health maintenance
organizations and other managed care entities). BCNEPA incured significant time and
energy to develop and maintan its existing subscriber base by providing quality products and
servces at a competitive price. In addition, it was necessar for BCNEP A to allocate
significat marketig resoures to develop new subscribers to replace lost subscribers and to
achieve grwt; The priar activities involved in atttig potential new subscribers
included maket reseach, new product development, extenive adversing and marketing
campaign (television. print, and raio), and promotional speeches by key executives.
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C. Description oftbe Assembled Work Force
There ar many benefits associated with having an assembled and trained labor and
management force. If one were to acquir all of the assets of BCNEP A, but not its existing
persnnel, one would have to incur certain expenses associated with the development of an assembled and trained work force. It is the measure of these expenses, or replacement cost,
that provides an indication of the fai market value of the assembled work force.
At Janua i, 1987, the composition of BCNPA's work force, basd on the employment
classificatons used by the Company, was as follows:
Employment Classification
Exempt Employee
Number of Employees
Offcials Executive Committe
Management Advisory Commttee
4 4
9 16 7
5
Mangers
Enrollent Managers
Admnisttive
Representatives
9
18
3
Supervsors
Systms Accountats
12
Sta
~
89
Sub-tota
Non-Exempt Employees
il
308
Tota
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III. VALUATION
A. Introduction
All valuation methodologies applied to an apprasa of any form of propert can be broadly
classifed into one of thee approaches. These are the cost approach, the market approach,
and the income approach. In any apprasal study, all thee approaches must be considered,
and the approach or approaches deemed most probative to valuing each element of propert
wil then be selected as the proper approach(es) to use in the valuation of that item of propert .
Each valuation approach is explained more fuly in the following report sections. The
remaider of the valuation section of this report then descrbes the valuation of
the designated
intangible asset.
J. Cost ADDroach
The cost approach establishes value based on the cost of reproducing or replacing the
propert, less depreciation from physica detrioration and fuctional and economic
obsolescence, if present and meaurle, Ths approach can be used to provide a reliable
indication of value when applied to specific assets, such as land improvements, special-
purose buildings, special strctus, systems, special machiner and equipment, and certain
intagible assets - pacularly those that have been developed internaly by a company.
The cost approach begins with an estimation of cost of reprouction new ("eRN") or
replacement cost new. eRN is defined as the cost of a new exact replica of the appraised
asset, basd upon curent prices of materials and labor rates prevaiing in the parcular ara,
plus, if applicable, genera contractors' overhead and profit, arhitectur and engineering
fees, and indire field costs. Replacement Cost New is the cost of an asset that is equivalent to the existing asset in term of fuction or utility. but not necessarly in design or materials
of constrction. For example, a modem replacement buildig for an existig stcture tht is
antiquated and ineffciently designed may have a relacement cost new that is less tha
reproduction cost new,' due to more moder technology or more effcient design and layout.
Similarly, a softare system tht can be designed for newer hardware with significantly
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fewer lines of code may have a replacement cost new that is less than reproduction cost new,
due to chages in technology.
Staring with eRN, an allowace for the varous components of depreciaton is deducted to
arve at the maket value of the asset These components of depreiation may include
fuctional obsolescence (present in the fonn of excess capital cost and/or ineffcient utilty), physical deterioration (curble and incurable), and economic obsolescence. An example of intangible assets would be a provider network.that depreciation applicable to the valuation of
might have measurable fuctonal obsolescence if ineffcient planng of the geographical
placement of the providers caused a decrease in revenues in comparson to the potential level
of revenues with optimum geographical dispersion, In genera, physical deterioration is not a
relevant factor in the valuation of intagible assets by the cost approach, since these assets,
by definition, are intagible and generaly do not have a physica presence.
2. Market ADDroach
The market approach is used to estimate value thugh anysis of recent sales of comparble
property. The value of an ast is meaured by comparng the asset with market transactions
involving similar assets, adjusd for dierences such as time of sale, physical chateristics,
earing capacity. and conditions of sale. The process is essentially that of a comparson' and
correlation between the subject asset and similar asts.
Use of the market approach reuire a reasonably active market for either the asset.being
valued or similar assets. In the valuation of real estte, similar propertes recently sold or
offered for sale in the curnt maret ar anyzed and compard with the property being apprased, and adjustments are made for diferences in such factrs as date of sale; location,
size, shape, and topogrphy of the land; typ, age, and condition of the improvements; and
prospective use. Ths approach is also used in the valuation of machinery and equipment for
which there is a known used market. The use of a market approach in the valuation of
intagible assets is often limited, however, since many classes of intagible asts typically
do not trde on an open market or caot be sold separte and apar from the other operating
assets of
the business enterprise.
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3. Income Aooroach
The term "income" as used in this approach is a general ter tht connotes any future
benefits that can be quantified in moneta terms. It does not imply that the income approach
should be used only with projections of "income" in the accounting sense. Rather, the income approach involves two genera steps. The fit is makg a projection of the total moneta benefits expected to accrue to an investor in the propey. (Exaples include
dividends realizable from an investment in common stock, rental savings from the realization
of a leasehold interst, or cash flows generated by a subscriber.) These future monetar
benefits must include, where appropriate, any cash flows that result from ta savings
associated with the ta amortization of, or othr ta deductions related to, the decline in value
of the
asset.
The second step involves discountig these moneta beefits to present wort at a discount
rate that considers both the degre of risk (or uncerty) associated with the realizatiòn of
the projected monetar benefits, as well as the strta of taes included in the projection (i.e.,
precorporate ta, afer-corporate ta and pre-individual tax, or afer both corporate and
individual taxes). Everying else being equa, the higher the risk, the higher the discount
rate, and the fewer strta of taxes included in the projection, the higher the discount rate.
Thus, in all its forms, the income approach can be described as an approach to value based on
discounting to present wort the expected futue benefits generated by an invesunent in the
propert being valued. The valuation methodology termed discounted cash
flow ("DCF") is
a form of income approach often used in the valuation of entire businesses or cerain
intagible assets of a business.
The income approach is often used in the valuation of income-producing real estate, as well
as in the valuation of may intangible ass. In the valuation of intangible asset, elements
of the income approach and the market approach are often used simultaneously. For
example, in the valuation of a leaehold interest, a maket comparison of renta rates
estalishes a curent leahold advantage used as the basis for a projected anua advantage,
and the projected advantage is then discounted to present wort. Similarly, for trdemarks, a
market invesgation establishes a curnt fai royalty, and ths amount is then used as the
basis for a projection of
royalty savings to be discounted to present wort.
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B. Information Resources
The primar information resoures usd durng the coure of our valuation procedures
included historical financial statements and cost report provided to extern paries, internally-generated management information systems ("MIS") report, and management
interviews. The finacial sttements and cost reports included Annual Reports and Audited
Financial Statements for 1984 thugh i 986, Annual Statements /0 the Insurance
Commissioner of the Commonwealth of Pennslvania for i 984 though 1986, the National and Blue Shield Association for 1986, and varous companyCost Report to the Blue Cross
generated MIS reports.
In performing our anyses, we also relied on extensive discussions with key members of the
BCNEP A manement team, several of whom were employed by the Company as of the
valuation date. These intervews focused on the overl operations and the anticipated
dirction of the Company as of the valuation date; the organzation of the Company and the products it offered; the procedures, processs, and costs involved in the development of the asets unde study; and, the anticipated futu profits associated with the asets under study.
Followig is a list of
the key BCNEPA persiiel who were intervewed:
Curnt Title
Director, Membehip and Biling
Manger, Application Systems
Director, Actuaral & Underting
Directr, Cost, Budgets, and Financial Systems
Directr, Finacial Services
Director, Provider Reimbursement & Contracting
Site Director, Shared Services Center
Analyst, Shared Services Center
Maer, Human Resource Payrll Accounting
Manger, Human Resoures and Employee Benefits
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In addition to the individuals listed above, we held numerous discussions with and received
supportg documentation from severa other BCNEP A pernnel in the areas of finance,
cost accounting, underwting and actuaal, marketing and development, claims processing,
human resoures, information systems, and hospita negotiations and contrcting.
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C. Valuation of the Employer Group Contracts Subscriber Base
1. Introduction
We employed the income approach to value BCNEPA's employer group contrcts subscriber
base. In ths approach, a separte valuation model was developed for each of the 8,865
employer group contrcts. Premium revenues, clais expens, opeating expenses, pro
forma income taes, reuid return on other asts employed, and miscellaneous
adjustents to cash flows were prjected over the expected reaining life of the contrct to
estate the net cash flow attbutale to the contrct. These net cah flows were then
discounted to present value at an appropriate rate, and an amount was added for the estimated
benefit of ta savings frm amortization, to provide an indication of fair market value of each
employer group.
As mentioned above, a separate valuation analysis wa performed on each of the 8,865 employer group contrts, due to the fact that there were several independent vanables that
impacted the value of a contrct One critical independent vanable was the expected
remaining life of each contrct, which vared depending upon the contrct's curent age. Other independent varables impacted the calculation of premium revenues and claims
expense. These included the type of employer grup (local versus national), rating
(commwuty versus experience raed), size (based on the number of subscribers within each
group), and tye of coverage (basic, baic with drg, basic with major medical, or basic with
drg and major medical),
At our reuest, BCNEP A mangement creted a data file, on computer disk, of the 8,865 employer group contrts in existence at Janua I, 1987. The fie contained the following
information:
1. Name of employer group
2. Contract number
3. Type (loca or national)
4. Ratig (experience or communty rated)
5. Siz (number of
subscriber)
6. Original effective date
7. Termination date (if applicable)
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A summar of the number of contrcts that were included in the data file created is as
folIows:
Tvne of Contract
Basic
Number of
Contrts (a)
1,078 5,202 1,870 715
Loc - Experience-Rated
Local - Communty-Rated
Local - Rating Unkown
National- Experience-Rated
Sub-total
8,865
Drg
Major Medical
90
7.319
16,274
Grand Tota
(a) Grad tota exceeds 8,865 becaus of combination
coverages among basic, drg, and major medical.
This data fie sered as the basis for our valuaon of the employer group contrcts subscriber
bas. A listing of relevant dat (nae of employer group, identifying contract number, star
date and, Ü applicable, termination date) from the data fie and the individua values
calculated for each of the 8,865 employer group contrts is being provided in both electronic
and hardcOpy format under sepate cover. A descripton of the key independent varables
that enter into the valuation of eah employer grup contr is contaned in the following
report sections.
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2. Premium Revenues
We calculated 1986 premium revenue for each employer group contrct in order to provide
the staing point for projecting premium revenues over the expected remaining life of each
contrct. Future premium revenues beyond 1986 were projected based on estimated growth
in clais expense, and the maintenance of appropriate claims expense ratios based on
historical averages. We used an anual grwt rate in premium revenues of 7 percent basd
on changes in the health care cost index durg the i 982 to i 986 period as well as
information provided by BCNEPA maagement as to its expectations as of Janua 1. 1987.
Claims expense ratios were estimated based on an anysis of histonca claims expense ratios
by contract ty, as shown in Exhbit C. Based on ths analysis, the following claims
expense ratios were selected as appropriate:
Type of Contract
Local Basic Drug Major Medical
(% of
Claims Expense Ratio Premium Revenues)
94.5% 91.0% 96.0% 90.0%
All National
Applying the growt rate and claims expense ratios yielded tota premium revenues assuming
100 percent retention in eah of
the projection yeas.
3. Life Study Analvsis
A key component of the employer group contracts subscriber base valuation was the life
study anysis relating to the employer grup contrcts. The objective wa to identify a
patter of mortity (terination of contrcts) tht would be used to forecat the probabilty
of an individua employer grup contr terminating in each year of the projection penod usd in the valuation modeL. This surival probabilty fuction was then usd in the
vauation model for eah individua employer grup contrt to estimate the expected
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premium revenues to be generated by that employer group contrct in each year of the
projection period.
Because we were performing a retrospective stdy (to
the Janua 1, 1987, valuation date),
we needed to define the data to be used in performing the life study analyses. Our first
gudeline wa to use only inormation that existed at the valuation date, or tht could have been reasonably anticipated at that date. If reliable histrical information did not exist from
prior to the valùation date, we considered whether the us of actu data from subsequent to
the valuation date, would be appropriate. For the subject life study analyses, given the
availabilty and estmated reliabilty of data frm prior to the valuation date, we first
considered the results of a life study analysis based solely on this historical information.
Data frm subsequent to the valuation date wa then us to adjust our findings based 01' the
use of data from prior to the valuation date.
The expected fue atttion for a group of employer group contracts, and the derived
surival probabilty fuction for an individua employer group contrct, was predicated on a
surivor fuction, caculated by combining the data files described above for the existing
Janua I, 1987, employer group contrcts and for the employer group contracts that
tennnated prior to Janua I, 1987, The surivor fuction projects, at the varous age
intervals, the cwnulative proportion of contrts remaining open. The projected anual retirement rates are the proportion of contracts retiring in a given age interval, afer having surived up to tht age interval. The projected proportion of contracts remag active is
one minus the retirement rate. The surivor fuction is therefore the cumulative proportion
of contrcts remainig active tlugh a parcular age interval.
The estimated remainig life of the employer group contrcts is detrmined by meaurng the
area under the surivor cure. Because both active and termnated contrcts have been used
to derive the survor cure, the cure does not decay to 0 percnt for the oldest age group
observed. Such cures ar caled stb surivor cures. With a stub surivor curve, the
average life calculation is biased because the cure does not decay to 0 percent. An unbiased
determintion of estated remaining life can be obtaed by projecting a completed surivor
cure. One metod of derving a completed survor cure, and the method used in our
analysis, is to observe anua retirement rates and perform a regression . analysis of the
historical anua retiment rates agai age in a polynomial regrssion fuction.
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For age intervals beyond the rane of observation, we assumed the retireent rates were equa to the rate observed in the oldest observed age interval. To ensur the surivor fuction decays to zero percnt in a reaonable time period, a maxmum age of 50 years was
assumed.
Basd on the anyses described above using only inormation from prior to the valuation
date, a surivor fuction wa calculated and was used to estmate an i 8.6 year estimated
remainig life for all contrcts. We then considered actual termination dat for both a thee
year period subsequent to the vauation date (the th yea ended December 3 i, i 989) and a nie year period subsequent to the valuation date (the nine yea ended December 31, 1995).
The use of these data resulted in a 14,6 yea estmated remaining life and a 13.0
year
estmated remaing life, respectively, for the thre year data and the nine year data. This
seems to suggest that as time evolved, tenation rates increased; an event that would not
have necessaily ben foreseeable as of Janua 1, 1987. However, in order to be
conservative in the valuation of the employer grup contrts, we made a downward adjusent to the retirement rates that reslted frm the historical analysis, The resulting,
adjustd estimated remaning life is approxiately 15 yeas, which appear to be
corroborated by the th year subsequent anysis.
The adjusted survor cure that yields the 15 yea esmated remaining life projects the
attrition of new contrcts. The projected attion of an existing contrct usually differs from
the atttion of new contracts because retirment rates are not constant. Thus, the predicted
surivor fuction has to be adjused by tang into account the curent age of each individual
employer grup. This is acomplished by deriving surivor fuctions for each age cohort (or
anual age inteal). The resuting suivor cures for each age cohort were then converted
to a suriva probabilty fuction by considerng the retirement rates in each year and the
cumulative probabilties of suriva versus tennination for each year of
the projection perod.
The results from our anyses indicated separte suval probabilty fuctions for employer
group contrcts with origination years from 1969 to 1986, as shown in Exhibit D. For contracts with origination yeas prior to 1969, the sae surival probabilty fuction wa
used as for those contrts tht originated in 1969.
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Applying the appropriate surival probabilty fuction to the projected premium revenues for
each individua employer group contract yields the anticipated or expected anual premiums revenues for each individua employer group contract.
4. Claims EXDenses. Gains from Underwritinii. and Ooeratinv Expenses
Clais expenses were esmated separately by contract tye, as described above in section
C.2., Premium Revenues, In estimating the pro forma gais from underiting to be used in
the projection period, we considered historical results over the 1982 to i 986 period, as well as information provided by BCNEP A management regarding its premiwn pricing policies
and the impact of invesent income on these pricing policies. A suar of the data
analyzed is presented in Exbit C. Basd on this analysis, the following pro form gains frm underwting were selecd as apprpriate:
Pro Forma '
Tvoe of Contrct
Local Basic Drug Major Medica
Gains frm Underwting
(% of
Premium Revenues)
5,5% 9.0% 4.0%
10.0%
All National
Operating expenses included genera, admintive, overhead, and any anticipated one-time
expenses. Based on an analysis of the actual operatig expense ratios over the i 982 to 1986
period, again as shown in Exhibit C, unadjus operatig expnses were projected at 3.1
percent of premium revenues. These unadjusd operating expenss include costs related to
the maintenace of the existng subscriber bas, such as clais processg, customer servce,
and a porton of genera overhead expense. In addition, these opeating expenses included
certn cost tht were not related to the matenace of the existng subscriber base. such as
advertsig and marketing cost associated with identifying and attcting new subscribers, costs associated with developing new providers and, again, a porton of overhead costs.
Based on a detiled anysis, it wa estimated that approximately 9 pecent of operating
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expenses were unelated to the maitenance of the existng subscriber base. As such, these unelated expenses were added back to the opeting profit figures to arve at an estimate of
operatig profit associated with each employer group contrt.
We arved at operating profit for each employer grup contract by estimting the pro forma
underwiting gain and deducting adjusted operating expenses.
5. Unadiusted Net Cash Flow Attibutable to Contracts
The next step wa to caculate and deduct the estated pro forma taes associated with the
anual opertig profit stream. Since BCNP A is considered a chartable, not-for-profit
organiztion in Pennylvana, it is exempted frm paying any stte premium or income taxes.
Federal income taes were deducted at the top marginal income ta rate of 46 percent prior to
July 1, 1987. and 34 percent afer July 1, 1987. of adjusted operating profits. The resulting
amoWlts represented afer-ta income attbutable to the remaining contrcts.
To arve at a net cah flow figu, one must consider any incrementa working capital needs
and net capita expenditue requirements (capita expenditus in excess of depreciation
expense). Since projected anual premium volume remains relatively constat or decreases in futur years as the number of contracts declines, it was determned that no additional net workig capita would be required to support the existing subscrber bas. To estimate the
net capita expenditues requird to support the existing subscnber base. we first estmated
net capita expenditu reuirements for the overa Company. Based on an analysis of
histonca net capita expenditus, discussions with mangement concernng anticipated
capita expnditu needs, and research concernng tyical net capita expnditus for the
industr. anua net capital expenditus requird to support the existng subscnber base were
estimated to be approximately 0.04 percent of premium revenues. Ths percentage wa then
applied to the premiums relating to the existing contrcts to arve at anticipated net capital
expenditue requirments. Ths amount wa then deducted from the after-tax income figues
to arive at an estimate of
the undjusted amua net cash flows attbutable to each employer
group contrt.
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6. Estimated Returns Required on Other Assets Enwloved
There were several other categories of assets, including tangible and intagible assets, that
were considered necessar to be employed in order to generate the retus calculated as
described above. The tangible assets included net working capital and fixed assets (land and
building, capitaizd lease, leaehold improvements, and equipment, furniture, and fixtures).
The intagible assets included computer softwar, assembled work force, and hospital contrcts,
The amount of net workig capita necessar to be employed in support of existing contracts
wa considered to be minimal, given the fact tht, excluding investments, the book value of BCNEPA's short-term liabilties has historicaly consistently ben grater than the book value of its short-term assets, For the puroses of ths analysis, and in order to be conservative, we estmated a reuired net working capita amount at one perent of 1986 subscription revenues. Tlus yielded a required net working capita amount of $2.45 milion
(rounded). For the Company's real property fixed assets (land, building, capitalzed lease, and leashold improvements), grss book value, or original cost, of $4.5 milion (rounded)
wa considere to be a reasonable approximation of fai market value. For the Company's
persona propert fixed assets (equipment, future, and fis), we relied on an appraisal
prepad by Amerca Apprasa Assciates and dated September 3, 1987. A copy of selected pages frm this report is mataed in our working papers. In their report
American Apprasal Assciates apprased the personal propert assets at $ 1.0 milion
(rounded) as ofJanua i, 1987.
In estmating the fair maket value of
BCNEPA's computer softar, we relied upon another
valuation report prepared by American Appraisal Associates and dated March 16, 1989. A
copy of ths report is maintaned in our workng pape. In their report, American Appraisal
Associates appraised the computer soft developed by ile Shad Servces Center at
$746,000 as of Januar i, 1987. Of this amount, $219,350 wa specifically allocated to softare developed for BCNEPA systems (claims, and membership and biling), $114,124
was specificaly allocated to softare developed for Capita Blue Cross systems, and the
remainder wa unalocated between BCNEP A and Capita Blue Cross. Using ile amount
specificaly allocated to BCNEP A systms and one-haf of the unallocated amount, we
estmated a fair market value for BCNPA's computer softare of$426,OOO (rounded).
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The fair market value of
BCNEPA's assembled work force has been estimated at $659,000,
as described in detal in subsequent report sections.
The fair market value of BCNPA's hospita contrts has been estimated based on a cost
approach to value, using compative data from valuations that we have perfonned for other
Blue Cross orgaIzations. As previously descrbed, BCNEPA's provider network consisted
of contracts with 30 hospitals. The cost involved in re-creating ths provider base include
the time required to identify a potential new hospita, meet with hospita executives, develop
biling rates/reimburment guidelines, and negotiate the contrt. Using the previously-
developed guidelines as describe above and giving recogntion to the substantial market
share held by BCNEPA as of Januar 1, 1987, we have estimated an aggrgate fair market
value of $
1,574,000 for the hospital contrcts.
With the exception of the fixed assets and the assembled work force, it was concluded that
the above asset supprted only the existing subscriber bas, It wa concluded that the fixed
assets and asembled work force, however, supported other activities as well as servicing the
existing subscriber bas. To estimate the portion required to support the existing subscriber
base, we assumed a similar relationship to the one usd for operating expenses. As indicated
previously, our anysis detennined that approxiately 9 percent of the operating expenses
were not related to supportg the existing subscriber bas. As such, this percentage was
applied to the total retu requird on the fixed assets and on the assembled work force to arive at the re required to support the existing subscriber bas. The overall dollar retu
required on the asets supportng the subscriber base wa then allocated to the various
contract categories basd on net premiums. The surivor cure employed in each contract
category anysis wa then applied to the tota dollar retu allocated to that contract category
to arve at an esmate of
the futue anual dollar retu required on assets employed,
Anua requird rates of retu for each of the asset clasifications described above were
based upon consideration of
both the Company's estimated weighted average cost of capital
(estimated at 16.9 percent as discused in a subsequent report section) as well as prevailing
market interest raes as of Janua 1, 1987. Becaus a weighted average cost of capital is
based on lower requird rates of retu on net workig capita and fixed assets, and corrspondingly higher reuired rates of retu on intagible assets based on their risk
chactristics, the reuire anua raes of retu were vared by asset classification.
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A sum of the estimated fai maket values, amounts allocated to existing contrcts, and
reuire anua rates of retu for the tagible and intagible assets described above is as
follows:
Estimted
Fair Market Value
($OOOS)
Amount Allocable to
Required
Annua
Return Rate
Existig Contrac
($0005)
Required Net Working Capital Fixed Assets
Computer Softar
Assembled Work Force Hospital Contracts
2,449 5,467 426 659 1,574
2,449 4,975 426 600 1,574
7.5% 9.0% 15.0% 20.0%
17.0%1
7. Discountinl! of
the Adiusted Net Cash Flows Attributable to the Contracts
The discount rate approprate for use in valuing the intagible asse of a company is
tyicaly set bad on its relationsp to the company's estimate weighted average cost of
capita ("W ACe"), and is developed in a proess that incorprates asects of economic
theory and capita budgeting teclmiques. To arve at an estimate of the W ACC, a capita
strctue model is deveioPed, and the cost of each component (debt and equity) is
approximated followig a review of market yields at the valuation date. The W ACC is then the component costs. calculatedbased on the weighted average of
CaDi/of Structure
Curnt finacial theory sttes that while an average optium capital strctue does
exist for a portolio of firms in an industr, no optimum stctu ca necessily be calculated for any given fi. Therefore, the capita strctue usd in the W ACe calculation is typically estimated basd on an anysis of varous publicly-trded
compaes engaged in a similar line of
busines as the subject company,
We began the process to identify these companes by screening the Compustat Indusal dabas for publicly-trded companes listed in the following Stadar
Industral Clasifications ("SIC") codes:
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. 6321 (acident and health insurance)
. 6411 (Insce agents, brokers, and service)
. 6311 (Life Insuace)
This initial. screen yielded 144 companes. Next we eliminated those companes whose business was signficantly different from BCNEPA's (e.g., reinsurance companes) or tht were significatly larer or smaller than BCNEPA. This screen yielded a remaining list of28 companies. Finally, we elimted those companies for
which adequate financial information (e.g., balance sheet, income statement, and/or
stock pnce information) was not availble as of Januar I, 1987. Ths final screen
yielded a list of
five companies (the "guideline companies").
Based on an anysis of the capita stctus of the guideline companies dunng their
most recent fiscal year ended pnor to Janua I, 1987, a capital strctue model of 15
percent debt and 85 perent equity wa considered resonable for use in this analysis.
Cost of Debt
The pre-tax cost of debt was estmated based on a consideration of market debt rates for senior debt and subordinated debt, and is intended to reflect as closely as possible
the actua magin borrwing rates for BCNEP A. Following is a sumar of maket
interest rates for debt near Janua 1, 1987:
Pnme rate
7.50%
Stadard & Poor's Corporate Bond Yield Averages
AM 9.17% AA 8.48% A 9.31%
BBB 9.52%
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Based on the above information and after consideration of BCNEPA's finacial
condition and borrwing capacity, a pr-ta cost of debt of 8.5 percent was considered
reasonable for use in this analysis.
Because interest expense is ta-deductible, the pre-ta cost of debt was converted to
an afer-ta rate using a statutory marginal ta rate of 34 percent (reduced from 46
percent effective July 1, i 987). Therefore, the. afer-ta cost of debt wa estimated at
5.6 percent (equal to 8.5 percent times one minus 34 percnt, rounded).
Cost of EQuity
The cost of equity was estimated by usng the Capital Asset Pricing Model ("CAPM")
to relate the retus equity investors require to the rik-fre retu as approximated by long-te goverent securties. To accunt for relatve risks for specific industres, the additional returns or risk preiaum require by the maket in general can be
adjusted by an factor known as "beta". The CAPM fonnula is as follows:
Re =Rf+ B (Rm - Rf)
Where:
Re
a:
Reuired retu on equity
Rf
B
=
=
Risk-fre rate of
retu
the relationsp
Beta a measure of
between indust risk and the
aggrgate maket
Rm - Rf
=
The expected retu of exces of
the maket in
the risk-fr rate
The rigorous version of th CAPM is not applicable for privately held firm or small
companies, whether privately or publicly held, Therfore, to be more applicable in
ths situation, the CAPM has ben adapte as follows:
Rei = Rf+ (B (Rm - RDl + SSP +/- RPj
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Where:
Rei =
SSP =
Required long-tenn retu on equity for the
subject company
Small stock premium or the additional retur requied by an investor in small capitazation stocks
Company-specific risk, or the additiona positive
or negative increment to the total retu for
RPi =
systematic risk factors specific to the subject company that ar not alreay captured in the beta or in the SSP risk premium.
and where all other tenns remain the same as above.
Risk-Free Rate The yield to maturty on a 20-yea Treasur bond was used to approxiate the
risk-fre rate. Whle the longest-tenn matuty governent bond is generaly
considered to be the best approximation of a risk-free rate and 30-year Treasur bonds do exist, the yield to matuty on a 20-year Treasur bond is
not afected by the additional demand for 30-yea bonds that arses from being
the longest matuty securty available. At Januar I, 1987, the yield to matuty on a 20-year Treasur bond wa 7.39 percent.
iJ
Beta wa developed frm a stdy of the stock beta of the guideline
companes. The unadjusted be coeffcients for each of the guideline
companies were those reported by IDD Inonntion Servcesfraeline, and
were calculated using a regression analysis basd on 60 months of data from December 31, 1981 to December 31, 1986. The unadjusted beta coeffcients
were then adjusted by the "Blume adjustment" factor, which adjusts for the
tendency for beta to regrss towards one over tie. Finally, in order to adjust
for the effect of fiancial leverae on each guideline company's beta the adjustd beta were first "unleverd" basd on th compay's actual debt-toequity ratio and then "releverd"' basd on the capita stctu developed as
discussed abve. Based on these data and analyses, a (relevered) beta of 0.9
was considerd reaonable for us in this anysis.
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Equity Risk Premium
The expected retu of the market in excess of
the risk-free rate was estimated
based on studies of both actual. historical stock market retus (Stocks. Bonds
Bils, and Inflation: 1987 Yearbook, Ibbotson Associates) and estimates of
expected fu preiums (APT!, Alcar Associates). The Ibbotson study
calculates historical premiums while the Alcar stdy estimates futu expected
market risk premiums. A sunar of the historical equity risk premiums for selected historical periods and the expected futue risk premium is as follows:
1926 to 1986 1966 to 1986 1976 to 1986
Expected future preDUum
7.36% 2.35% 5.53% 4.44%
Based on the information shown above for both actu historical and expected
futur premiums, we concluded that an equity risk premium of 5 percent was
reasnable.
Small Stock Premium and ComDanv-$pecific Risk
The Ibbotson studies also identify a smal stock premium based on sties of
low capitaiztion stks. defied as the lowest quintile of stocks (based on
market capitaliztion) tred on the New York Stock Exchage. This preium
recognis the fact th equity holders demd a lugher retu from compaes
that are smaller in siz and in tota caitaizati